Rating Agencies: Disease and Cure

Today Congress put credit rating agencies on the hot seat during intense hearings. Rating agencies, including Moody’s and Standard & Poor’s, gave top grades to debt the credit crisis is now showing everyone was junky. Scholars have long berated the rating agencies, especially Frank Partnoy. The fundamental problem is that securities issuers pay the rating agencies their fees. The proverbial result: whose bread I eat, his song I sing. Also, law requires very little of rating agencies and essentially insulates them from liability to investors harmed by irresponsible ratings.

As Congress turns hearings into policymaking, Members should consider new scholarship from Jeffrey Manns forthcoming in North Carolina Law Review. He proposes that investors, not issuers, pay rating agencies. The so-called user fee system is coordinated mainly by investors, those owning rated bonds, with a government agency coordinating the system in the pre-issuance stages of a rated debt offering. In addition, rating agencies would have to certify their ratings much as auditors certify their audits. Also like auditors, agencies would be required by law to disclose discovered fraud or illegal acts at issuers whose securities they rate.

The proposal is timely and sensible. Inevitably, it contains elements worthy of debate as well. In particular, the proposal contemplates applying a standard of gross negligence for investor recovery for rating agency violations. The standard for auditors generally is the tougher one of recklessness. In addition, the proposal caps rating agency damages measured in relation to earnings from the botched rating. Despite decades of campaigning by auditor lobbyists for such a cap on their damages, they have not been able to win this victory. Also, alas, auditors continue to be paid by the clients whose financial statements they audit (which I’ve proposed addressing by using financial statement insurance or capital market funding to prevent destroying the auditing industry).

Those interested in preliminary diagnosis of causes and cures for the current crisis should read Manns’ new article. My guess is that everyone who has written or thought about the rating agency’s role in our corporate finance system will consider the piece must reading.

3 Responses

I’ve learned a lot from Jeff’s previous work and look forward to reading this. By the way, here are some ideas Alan Blinder mentioned:

“My Princeton colleague Dilip Abreu suggests paying ratings agencies with some of the securities they rate, which they would then have to hold for a while. Robert Pozen, head of MFS Investment Management, wants independent investors in the conduits to hire the agencies instead. Another idea would have a public body, like the S.E.C., hire the agencies, paying the bills with fees levied on issuers. If you have a better idea, write your legislators.”

I think we Credit Ratings Agencies should disclose how they are getting paid. I also think they shouldn’t have a government charter or be connected in any way to the SEC. Their formal role as regulators probably helped deceive investors in some fashion.